With unprecedented levels of private equity dry powder (unallocated investment funds awaiting deployment), we see growing optimism that investment conditions will improve for mid-market technology and tech-enabled companies in 2023. With that in mind, investment advisors are urging these businesses to begin exit prep now in preparation for a formal M&A process – or even for the increasing likelihood of being approached by an unsolicited buyer or investor in the coming months.
Similar to preparing a home for sale, businesses looking to sell must take steps to ready the business for an efficient and competitive process. Traditionally, preparing for a transaction has focused only on legal, financial and strategy workstreams. But with technology considered a key differentiator, central to the competitive positioning of both pure-play software companies and tech-enabled services businesses, the tech story often takes center stage. Potential investors now expect tech teams to come to the table with technology documentation, evidence that supports tech KPIs and a strategic roadmap of critical technology initiatives. For many sellers, this process is new.
To address the tech workstream, businesses are increasingly engaging in a technology-specific exit prep initiative, guided by an independent advisor. This is a collaborative exercise to help a company understand the needs of potential buyers, learn how to tell their tech story and prepare for the transaction. The process helps a business mitigate risk areas, collect metrics and gather other evidence essential to preparing investor reports and engaging in a formal buy-side technical diligence later.
We spoke with Managing Director, Neal Fiske, and Director, Steve White, to learn more about the exit prep and sell-side diligence processes. Their combined experience includes helping more than 100 Crosslake clients through their sell-side transactions.
What buyers are looking for
For those who aren’t familiar with technical diligence, what are the key areas of focus?
Neal: Tech diligence looks at the technology, people and processes that are fundamental to supporting a business. The exact emphasis will depend on the target’s size and maturity and whether the target is predominantly building or buying software and technologies to support the business. In all scenarios, you’ll see a significant focus around the management of cybersecurity and privacy risks.
Steve: We’ve also seen a growing trend in tech diligence for tech-enabled service businesses and in pure IT diligence, where we look at a target’s business systems and IT infrastructure. These types of specialized diligences will skew the topics slightly. For example, in a tech-enabled business, it’s less about software development and more about change management. In IT diligence, our focus may be more around application architecture planning. An important aspect in all cases is to assess the technology, processes and people in the context of the wider value proposition or investment strategy to make sure that the diligence findings support the broader narrative.
What areas do buyers care about most in a technical diligence?
Neal: It really boils down to whether the technology, people and processes can and will effectively support the investment thesis – and whether key risks are understood and managed well.
Steve: As Neal said, it very much depends upon the specific investment strategy. But the most common high-level themes used to support M&A and determine fit into the investor’s portfolio are centered around scalability, sustainability/resilience and integration or acquisition opportunities. Security risks, as well as potential hidden costs (for example from insufficient investment) are common red flags that technical diligence can help to surface.
How valuable is a technical diligence report prepared by the seller? Do investors on the buy side consider it credible?
Neal: That depends significantly on both the quality of the external report itself and the reputation of the advisors who prepared it. In our buy-side work with investors, we often encounter technical vendor reports that read more like brochures than objective assessments.
Tech advisors are there to support their clients and the process. In order to draft a credible tech diligence report that is meaningful to investors, they must remain objective and truthful, acknowledging both strengths and gaps. At the same time, they must present a compelling path forward for differentiation and remediation, based on the evidence available.
Steve: An informative, credible, well-written report accelerates the investor’s ability to learn about and assess the target company. This may allow a potential investor to move more quickly, while incurring lower diligence costs on their side – something that they clearly appreciate.
Avoiding common pitfalls
How do tech companies tend to fall short as they approach exit?
Neal: A good proportion of businesses and individuals we work with have never been through an M&A process before, so they lack a clear understanding of how the process works and what investors and their advisors are looking for. From a purely tactical perspective, the most common miss we see is not having a comprehensive set of operational documentation – appropriate to the size and level of maturity of the business – that truly reflects how technology is delivered and managed to support the business.
Steve: There are three main areas that I see:
- Companies often overlook how their business practices may appear to an investor. Security is an example. Poor security practices can expose the investor to potentially catastrophic impacts – and a newly-acquired company with deep-pocketed investors becomes more attractive to cybercriminals.
- Sloppiness in data hygiene, processes and evidence (in the form of documentation and metrics) are also common weaknesses that can undermine the quality of what is actually taking place within the business.
- When technology team members are not sure how to answer buyers’ questions, or they have inconsistent messaging, this also impacts their credibility with investors. You need to have a clear and compelling tech story that comes through consistently.
What are you specifically looking for in the virtual data room (VDR) – and what do you commonly find missing?
Neal: In both buy- and sell-side tech diligence, we’re looking for documentation and metrics that provide evidence of the business managing its technology, people and processes effectively in its day-to-day operations. There are certain fundamentals, regardless of business size or maturity, that we’d expect to see as part of a company’s technology DNA. While PowerPoint presentations can help in pulling together content on a given topic, without appropriate living documentation and supporting metrics, the content can lack credibility.
Steve: I’ve never seen a VDR that answers everything we have asked for, but there are many that lack fundamental content, such as architecture diagrams, infrastructure documentation, product and technical roadmaps, open-source assessments and policies, cybersecurity and privacy policies and controls. Documentation is often an afterthought in technology, especially when delivery timeframes are tight, so it’s not unusual to have a team help pull together appropriate materials as part of the exit prep process.
While documentation and metrics alone won’t make a company grow, not having them can be an inhibitor. The VDR is key to demonstrating the effectiveness and consistency of standard technology procedures. A well-structured VDR, with a mixture of living documents, metrics, and materials to distill broader topics, increases confidence and eases the M&A process.
What are some factors that may prolong the technology diligence cycle?
Neal: When a diligence process is extended, it’s most likely due to changes in market conditions or very significant concerns arising in other, non-technology workstreams. In my experience, it’s rare for risks or issues identified in the technology workstream to impact the timeline. That said, such risks or issues can affect valuation.
Steve: When the target is not prepared, or when a material risk or uncertainty surfaces late in the process, you could see a buyer delay or challenge negotiations. Sellers can prepare with a sell-side diligence in advance to avoid any unnecessary mid-process uncertainty or friction. Through this process, you identify risks to mitigate prior to investment or sale – as well as opportunities that may not previously have been considered but are important to highlight for potential buyers.
The path to a smoother M&A process
How does sell-side diligence help the transaction process?
Neal: We normally deliver sell-side engagements in two phases. In the initial phase, we develop an internal-only, candid and objective summary. This initial report is written as if for a buy-side investor, and we set a high bar to prepare the company for the tough questions potential investors will ask. This is complemented by internal recommendations – a set of pragmatic remediations to move the needle on both risks and strengths. This first phase of the process, along with the resulting documents, helps sellers understand what is important to investors and helps prioritize activities that will improve the business and the M&A process.
In the second phase, we prepare an external investor-facing report that tells the company’s technology story. By aligning the company’s technology landscape to their broader value proposition, this report helps investors understand how the target fits into their investment strategy.
For credibility, it’s crucial that the external report presents an objective balance by providing evidence of ongoing remediation activities and plans. A credible external report helps reduce the likelihood of investors requiring additional, top-up diligence.
Steve: The overall process benefits both the buyer and the seller. While the seller benefits from a more efficient process, reduced risk and less effort and cost in engaging with multiple potential investors, the potential buyer gets a in-depth understanding similar to a full buy-side tech diligence – but without having to go through the entire process. This can be extremely valuable and often helps to speed the pace of the transaction.
How can exit prep help companies seeking investment?
Neal: One unique thing about technology due diligence compared to financial diligence is that you can prepare much further in advance. Think of exit prep as a “mock exam.” The intention is for the company to prepare for the M&A process with an objective view of how they might be viewed by a potential investor, and to engage in a candid and confidential discussion on what they can do to improve their standing.
Steve: While running technology often requires pragmatism, investors are often seeking the certainty and consistency demonstrated through processes, documentation and metrics. Understanding what matters to investors, and putting in place practices and evidence over a sustained period of time, is the best way to reduce investor uncertainty. This also demonstrates continuous improvement, providing confidence that the business can continue to improve following the transaction.
What’s the ideal timing to begin preparing for exit?
Neal: Ideally this would be conducted six to 12 months in advance of a planned exit – but exit prep just a few weeks’ prior is still very helpful in facilitating a smoother and more successful process. Any opportunity for pragmatic remediation is better than none! Even four to six weeks of focused preparation will usually allow for some simple but important remediations that can help improve the outcome.
Steve: Having the time to actually implement changes and to demonstrate progress over time through metrics or proven project progress carries more weight than simply being aware of weaknesses and risks or having plans that are not yet started. For this reason, it’s typically ideal to undergo sell-side diligence and begin preparing for exit up to a year before seeking investment or acquisition. Regardless of whether the transaction takes place, the recommendations that surface during exit prep will ultimately make the business better.
However, we know that many situations do not have the luxury of time. And as Neal stated, many of the benefits of a formal exit prep process still stand – even if the process is constrained to a very short time window.
If you’re preparing a tech or tech-enabled business for investment or exit, let Crosslake’s team of seasoned practitioners help you shape your tech story. We’ve completed more than 4,000 tech due diligences over the last four years and know exactly what investors and buyers are looking for.
About the contributors
Neal Fiske, Managing Director
With a global career spanning over 30 years, Neal has worked for and with start-ups, scale-ups and major technology companies such as Microsoft and IBM in a broad variety of roles. Using a wealth of skills and experience in software, SaaS and service delivery, he helps clients assess, transform and deliver value from their technology investments.
Steve White, Director
Steve has over 20 years of technology and leadership experience with practical, enterprise-level proficiency through roles in numerous multi-national organizations. He leverages his deep technical and business knowledge to deliver positive change through technology solutions, creating high-performing teams with an innovative and inquisitive approach to organizational practices. Steve’s strategic mindfulness and delivery focus are coupled with a hands-on leadership approach.